The IRS recently issued its final regulations on the new 20 percent deduction for Qualified Business Income (QBI) for pass-through businesses (Section 199A). This new deduction was added as part of the Tax Cuts and Jobs Act of 2017.
The final regulations are 247 pages long, and because this is a new deduction, there are many complexities and gray areas to consider. Our Weiss & Company LLC tax professionals are ready to guide you through the process of what you might be eligible to deduct. Contact our team to learn more.
What is the deduction?
Congress enacted Section 199A to provide a deduction of 20 percent of a non-corporate taxpayer’s QBI from each of the taxpayer’s qualified trades or businesses, including those operated through a partnership, S corporation, or sole proprietorship. A deduction of 20 percent is also available for the taxpayer’s aggregate qualified REIT dividends and qualified publicly traded partnership income. The actual deduction is claimed at the individual level.
What are the deduction limits?
Section 199A limits the amount of this deduction for a trade or business to the lesser of 1 or 2 below:
1) Twenty percent of the taxpayer’s QBI with respect to the qualified trade or business; or
2) The greater of (a) or (b):
(a) 50 percent of the W-2 wages with respect to the qualified trade or business; or
(b) The sum of 25 percent of the W-2 wages with respect to the qualified trade or business PLUS 2.5 percent of the Unadjusted Basis Immediately after Acquisition (UBIA) of all qualified property.
There is also an overall limitation of 20 percent of taxable income.
In order for a taxpayer to obtain the full benefit of the deduction without being subject to the wage and capital limitations mentioned above, and in order for a specified trade or business (SSTB) to be able to take the deduction under Section 199A, the taxable income of the taxpayer (shareholder, partner, member or sole proprietor) must be less than $157,500 or less than $315,000 in the case of a married taxpayer filing jointly. Once a taxpayer has taxable income in excess of $207,500 ($157,500 plus $50,000), or $415,000 in the case of a married taxpayer filing jointly ($315,000 plus $100,000), the taxpayer: (1) may not take any Section 199A deduction with respect to a “specified service trade or business” (SSTB); and (2) will be subject to the wage and capital limitations with respect to a qualified trade or business.
Section 199A also indicates that the QBI deduction is not available for an employee’s wages, guaranteed payments paid to partners, and for income from a “Specified Service Trade or Business” (SSTB). Generally, the SSTB are service-type businesses. Even if income was earned from a SSTB, the deduction might be available if the taxpayer’s taxable income is less than an applicable threshold amount.
The QBI deduction applies to taxable income and doesn’t come into play when computing adjusted gross income (AGI). It’s available to taxpayers who itemize deductions, as well as those who don’t itemize, and to those paying the alternative minimum tax.
Regulations to Consider
There are many regulations involved in Section 199A. Below we highlight a few that might be of interest to taxpayers.
Real Estate Rental Properties
One of the major unknown features of Section 199A is how to treat a rental property for purposes of the new 20 percent deduction. Would this be treated as a trade or business or not? The IRS offered two pieces of guidance to taxpayers.
1) The taxpayer should “enter into and carry on the activity with a good faith intention to make a profit or with the belief that a profit can be made from the activity.”
2) The IRS focused on the scope of activities and said this would require there to be “considerable, regular, and continuous activity” carried out by the taxpayer.
Under the proposed safe harbor, a rental real estate enterprise may be treated as a trade or business for purposes of Section 199A if at least 250 hours of services are performed each taxable year with respect to the enterprise. This includes services performed by owners, employees, and independent contractors and time spent on maintenance, repairs, collection of rent, payment of expenses, provision of services to tenants, and efforts to rent the property.
Other activities carried out by the investor are not under this safe harbor, and thus not included in this 250-hour threshold. The 250-hour threshold is part of the safe harbor, and it doesn’t necessarily mean the rental activity is not a trade or business; it just does not qualify under the safe harbor.
Unadjusted Basis in Qualified Property (UBIA)
The final regulations also make some changes regarding the determination of UBIA in qualified property. We thought that we might have to adjust the balance for transactions where the entity doesn’t recognize a gain or loss on a contribution in exchange for an interest or share, a like-kind exchange or an involuntary conversion. Under the final regulations, the balance generally remains unadjusted as a result of these transactions. Property contributed to a partnership or S corporation in a nonrecognition transaction usually will retain its UBIA on the date it was first placed in service by the contributing partner or shareholder. The UBIA of property received in a like-kind exchange is generally the same as the UBIA of the relinquished property. The same rule applies for property acquired as part of an involuntary conversion.
Limits for Specified Service Trade or Businesses (SSTB)
The QBI deduction is further limited for specified service trades or businesses (SSTBs). SSTBs include, among others, businesses involving law, financial, health, brokerage, and consulting services, as well as any business (other than engineering and architecture) where the principal asset is the reputation or skill of an employee or owner. The QBI deduction for SSTBs begins to phase in at $315,000 in taxable income for married taxpayers filing jointly and $157,500 for single filers, and phasing in completely at $415,000 and $207,500, respectively (the same thresholds at which the wage limit phases in).
The final regulations addressed each of the separate services and made several changes and added several examples. It is important to review each of these SSTB services to see what the IRS descriptions are for these services in order to learn what is treated as an SSTB and what is not.
Aggregation of Multiple Businesses
It’s not unusual for small business owners to operate more than one business. The regulations include rules allowing an individual to aggregate multiple businesses that are owned and operated as part of a larger, integrated business for purposes of the W-2 wages and UBIA of qualified property limitations, thereby maximizing the deduction.
A taxpayer who doesn’t aggregate in one year can still choose to do so in a future year. Once aggregation is chosen, though, the taxpayer must continue to aggregate in future years unless there’s a significant change in circumstances. In addition, the IRS will permit taxpayers to make initial aggregations on amended returns for 2018.
Connect with Weiss for QBI Assistance
The final regulations will impact many taxpayers and could have significant tax consequences in 2018, including additional complexity and compliance issues. But there are also some opportunities for taxpayers to reduce their tax liabilities if they understand and plan with these new rules in mind.
Contact a member of our tax department with any questions or for any assistance.